How China matters to your 401(k)

China’s markets are exerting themselves on the U.S. and other global markets

A map shows listed companies at the Shenzhen Stock Exchange in Shenzhen, China.

BEIJING — Zhou Ping, a Shanghai-based asset manager, finds himself increasingly fielding this question from across the Pacific: How does China matter to my 401(k)?

The question might seem odd when you consider that U.S. fund managers and other guardians of Americans’ retirement plans are largely “underweight” on China, meaning they allocate a smaller percentage of the portfolios they manage to Chinese shares listed in Hong Kong and New York compared with global benchmarks.

Mainland-traded stocks and bonds aren’t even included in influential suites of indexes compiled by MSCI Inc.
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and others and tracked by international portfolio managers because of China’s capital controls.

Despite the limited exposure foreign investors have to China’s stocks, bonds and currency, the country’s markets are exerting themselves on the U.S. and other global markets. In the past 13 months, two bouts of rapid yuan depreciation have sent global markets tumbling. The influence, many say, comes from doubts about Beijing’s ability to steer the world’s second-largest economy toward sustainable growth.

“No one can live with China instability,” says Zhou, founder of Bin Yuan Capital Ltd., which manages more than $400 million for U.S. pension funds, college endowments and other institutional investors.

Outsize impact

A continued Chinese slowdown and a drop in Chinese demand would depress the prices of everything from oil and iron ore to Apple Inc.
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shares — a fixture in many Americans’ pension plans.

Part of the impact also arises from Beijing’s efforts to integrate the country’s markets more closely with the rest of the world. To draw more investors from abroad as growth slows, Chinese authorities have increased quotas granted to foreign investors and made it easier for them to purchase mainland-listed stocks via a trading link with Hong Kong.

But investors in the U.S. and other countries remain skittish about putting money into China. One worry is that money can’t move freely in and out of China. In fact, the government has tightened restrictions on funds leaving China’s shores since late last year to prevent outflows. That, combined with an epic government-led market-intervention debacle last summer, contributed to MSCI’s decision in June not to add mainland Chinese A-shares to its indexes.

Of concern to U.S. investors is the yuan, often seen as a measure of Beijing’s ability to manage the economy. China’s shifting exchange-rate policies over the past year — marked by two surprise devaluations, in August 2015 and January, respectively — have spurred speculation that the economy is worsening faster than indicated by official data. In recent months, China’s central bank has improved communication with the market about its yuan-pricing system, helping ease some nervousness.

However, fears remain that Beijing might have to resort to sharp currency devaluation to help prop up growth if the economy decelerates further next year. “China’s exchange-rate policy is one of the top issues raised by U.S. investors,” says Zhou, a former portfolio manager with General Electric Co.’s
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asset-management arm. “How China manages the currency shows how well it is managing the economy.”

The MSCI wait

For now, U.S. investors’ direct exposure to China mainly comes from Chinese companies listed in Hong Kong and New York, such as internet giant Alibaba Group Holding Ltd.,
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telecommunication company China Mobile Ltd.,
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and Industrial & Commercial Bank of China Ltd.
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Those companies now make up a quarter of MSCI’s Emerging Markets Index, giving China the biggest country weighting in the benchmark. But those Chinese shares make up only 2.7% of MSCI’s overall global index. And they currently also represent “the biggest underweight” positions among global mutual funds, according to UBS Group AG, as investors are wary of unpredictable policy moves and a soft economy.

It may just be a matter of time before shares listed in Shanghai and Shenzhen get included in MSCI’s indexes, many investors and analysts say, pointing to China’s stated goal of opening its markets. Such inclusion means international money managers tracking the indexes would have to add A shares to portfolios. Mainland shares are less liquid and more expensive than their overseas counterparts.

Chi Lo, China economist at BNP Paribas Investment Partners,
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the asset-management arm of the Paris-based bank, estimates that A shares will account for about 20% of MSCI’s Emerging Markets Index if they get fully included.

“It matters more to U.S. managers than to other foreign investors because the U.S. managers are more underweight A shares than the others,” Lo says. (Currently, U.S. investors can only buy A shares with quotas approved by Chinese authorities.)

However, if other markets are any indication, the road to full A-share inclusion is likely to be a long one.

For instance, it took Taiwan and South Korea more than 10 years to have their stocks fully included in the MSCI indexes. For China, financial liberalization has already taken a back seat to maintaining stability amid the continued slowdown. Some say if China further eases repatriation of funds and meets other requirements set by MSCI, some 5% of A shares could be added to the emerging-markets index in the near term. If that happens, mainland equities would represent about 1% of the index.